Macroeconomics

I. Measuring a Nations Income and Cost of Living

 Economies Income and Expenditure
When judging whether the economy is doing well or poorly, it is natural to look at the total
income that everyone in the economy is earning. That is the task of gross domestic product.
GDP measures two things at once: the total income of everyone in the economy and the
total expenditure on the economy’s output of goods and services. GDP can perform the trick
of measuring both total income and total expenditure because these two things are really
the same. For an economy, income must equal expenditure. An economy’s income is the
same as its expenditure because every transaction has two parties: a buyer and a seller. GDP
measures this flow of money. We can compute it for this economy in one of two ways: by
adding up the total expenditure by households or by adding up the total income (wages,
rent, and profit) paid by firms. Because all expenditure in the economy ends up as
someone’s income, GDP is the same regardless of how we compute it
 Measurement of GDP
gross domestic product (GDP) the market value of all final goods and services produced
within a country in each period of time
GDP adds together many kinds of products into a single measure of the value of economic
activity. To do this, it uses market prices. Because market prices measure the amount
people are willing to pay for different goods, they reflect the value of those goods.
GDP tries to be comprehensive. It includes all items produced in the economy and sold
legally in markets. GDP measures the market value of not just apples and oranges but also
pears and grapefruit, books and movies, haircuts and healthcare, and on and on. GDP also
includes the market value of the housing services provided by the economy’s stock of
housing.
GDP excludes most items produced and sold illicitly, such as illegal drugs. It also excludes
most items that are produced and consumed at home and, therefore, never enter the
marketplace. Vegetables you buy at the grocery store are part of GDP; vegetables you grow
in your garden are not.
In addition, when the government reports quarterly GDP, it presents the data after they
have been modified by a statistical procedure called seasonal adjustment.
 Components of GDP
GDP (which we denote as Y) is divided into four components: consumption (C), investment
(I), government purchases (G), and net exports (NX):
Y = C + I + G + NX.
Consumption: spending by households on goods and services, with the exception of
purchases of new housing
Investment: spending on capital equipment, inventories, and structures, including
household purchases of new housing
 government purchases: spending on goods and services by local, state, and federal
governments
net exports: spending on domestically produced goods by foreigners (exports) minus
spending on foreign goods by domestic residents (imports)
Net Exports = Total Export - Total Import
 Real versus Nominal GDP
GDP measures the total spending on goods and services in all markets in the economy. If
total spending rises from one year to the next, at least one of two things must be true: (1)
the economy is producing a larger output of goods and services, or (2) goods and services
are being sold at higher prices.
Nominal GDP the production of goods and services valued at current prices
Real GDP the production of goods and services valued at constant prices
To sum up: Nominal GDP uses current prices to place a value on the economy’s production
of goods and services. Real GDP uses constant base-year prices to place a value on the
economy’s production of goods and services. Because real GDP is not affected by changes in
prices, changes in real GDP reflect only changes in the amounts being produced. Thus, real
GDP is a measure of the economy’s production of goods and services.
 The GDP Deflator
GDP deflator a measure of the price level calculated as the ratio of nominal GDP to real GDP
times 100
GDP deflator is calculated as follows:
Nominal GDP
GDP deflator = *100
Real GDP

Economists use the term inflation to describe a situation in which the economy’s overall
price level is rising. The inflation rate is the percentage change in some measure of the price
level from one period to the next. Using the GDP deflator, the inflation rate between two
consecutive years is computed as follows:
GDP deflator∈ year 2 – GDP deflator∈ year1
Inflation rate∈ year 2= * 100
GDP deflator∈ year 1

 The Consumer Price Index (CPI)

The consumer price index (CPI) is a measure of the overall cost of the goods and services
bought by a typical consumer.
 Calculation of CPI
1. Fix the basket. Determine which prices are most important to the typical consumer. If the
typical consumer buys more hot dogs than hamburgers, then the price of hot dogs is more
important than the price of hamburgers and, therefore, should be given greater weight in
measuring the cost of living. The BLS sets these weights by surveying consumers to find the
basket of goods and services bought by the typical consumer. In the example in the table,
the typical consumer buys a basket of 4 hot dogs and 2 hamburgers.
 2. Find the prices. Find the prices of each of the goods and services in the basket at each
point in time. The table shows the prices of hot dogs and hamburgers for three different
years.
Compute the basket’s cost. Use the data on prices to calculate the cost of the basket of
goods and services at different times. The table shows this calculation for each of the three
years. Notice that only the prices in this calculation change. By keeping the basket of goods
the same (4 hot dogs and 2 hamburgers), we are isolating the effects of price changes from
the effect of any quantity changes that might be occurring at the same time.
4. Choose a base year and compute the index. Designate one year as the base year, the
benchmark against which other years are compared. (The choice of base year is arbitrary, as
the index is used to measure changes in the cost of living.) Once the base year is chosen, the
index is calculated as follows:
Price of basket of goods∧services ∈current year
CPI= * 100
Price of basket ∈base year

5. Compute the inflation rate. Use the consumer price index to calculate the inflation rate,
which is the percentage change in the price index from the preceding period. That is, the
inflation rate between two consecutive years is computed as follows:
CPI ∈ year 2−CPI∈ year 1
Inflation rate∈ year 2= ∗100
CPI ∈ year 1

 GDP Deflator versus CPI

The GDP deflator is the ratio of nominal GDP to real GDP. Because nominal GDP is current
output valued at current prices and real GDP is current output valued at base-year prices,
the GDP deflator reflects the current level of prices relative to the level of prices in the base
year. Economists and policymakers monitor both the GDP deflator and the consumer price
index to gauge how quickly prices are rising. Usually, these two statistics tell a similar story.
Yet two important differences can cause them to diverge. The first difference is that the GDP
deflator reflects the prices of all goods and services produced domestically, whereas the
consumer price index reflects the prices of all goods and services bought by consumers.
This first difference between the consumer price index and the GDP deflator is particularly
important when the price of oil changes.
The second and subtler difference between the GDP deflator and the consumer price index
concerns how various prices are weighted to yield a single number for the overall level of
prices. The consumer price index compares the price of a fixed basket of goods and services
to the price of the basket in the base year.
 Correcting economic variables for the effects of inflation
The purpose of measuring the overall level of prices in the economy is to allow us to
compare dollar figures from different times. Now that we know how price indexes are
calculated, let’s see how we might use such an index to compare a dollar figure from the
past to a dollar figure in the present.
indexation the automatic correction by law or contract of a dollar amount for the effects of
inflation
  Real and Nominal Interest Rates
nominal interest rates: the interest rate as usually reported without a correction for the
effects of inflation
real interest rates: the interest rate corrected for the effects of inflation
Real interest rate = Nominal interest rate – Inflation rate.

II. Production and Growth

 Economic Growth around the world
Because of differences in growth rates, the ranking of countries by income changes
substantially over time. As we have seen, Japan is a country that has risen relative to others.
One country that has fallen behind is the United Kingdom. In 1870, the United Kingdom was
the richest country in the world, with average income about 20 percent higher than that of
the United States and more than twice Canada’s. Today, average income in the United
Kingdom is 20 percent below that of the United States and like Canada’s.
 Productivity: Its Role and Determinants
productivity, the quantity of goods and services produced from each unit of labor input.
Each of these determinants of Crusoe’s productivity—which we can call physical capital,
human capital, natural resources, and technological knowledge—has a counterpart in more
complex and realistic economies.
physical capital the stock of equipment and structures that are used to produce goods and
services
human capital the knowledge and skills that workers acquire through education, training,
and experience
natural resources the inputs into the production of goods and services that are provided by
nature, such as land, rivers, and mineral deposits
technological knowledge society’s understanding of the best ways to produce goods and
services
 Economic Growth and Public Policy
diminishing returns the property whereby the benefit from an extra unit of an input declines
as the quantity of the input increases
catch-up effect the property whereby countries that start off poor tend to grow more
rapidly than countries that start off rich
 Investment
policies aimed at increasing a country’s saving rate can increase investment and, thereby,
long-term economic growth.
A capital investment that is owned and operated by a foreign entity is called foreign direct
investment.
An investment that is financed with foreign money but operated by domestic residents is
called foreign portfolio investment.
 Investment from abroad, therefore, does not have the same effect on all measures of
economic prosperity. Recall that gross domestic product (GDP) is the income earned within
a country by both residents and nonresidents, whereas gross national product (GNP) is the
income earned by residents of a country both at home and abroad.
Thus, every country has an interest in promoting economic prosperity around the world. The
World Bank and the International Monetary Fund were established to achieve that common
goal

III. Goods and Money Market

financial system the group of institutions in the economy that help to match one person’s saving
with another person’s investment
financial markets financial institutions through which savers can directly provide funds to borrowers
A bond is a certificate of indebtedness that specifies the obligations of the borrower to the holder of
the bond. Put simply, a bond is an IOU. It identifies the time at which the loan will be repaid, called
the date of maturity, and the rate of interest that will be paid periodically until the loan matures.
The first characteristic is a bond’s term—the length of time until the bond matures. Some bonds
have short terms, such as a few months, while others have terms as long as thirty years. (The British
government has even issued a bond that never matures, called a perpetuity.
The second important characteristic of a bond is its credit risk—the probability that the borrower
will fail to pay some of the interest or principal. Such a failure to pay is called a default.
The third important characteristic of a bond is its tax treatment—the way the tax laws treat the
interest earned on the bond. when state and local governments issue bonds, called municipal
bonds,
The sale of stock to raise money is called equity finance, whereas the sale of bonds is called debt
finance.
Financial Intermediaries Financial intermediaries are financial institutions through which savers can
indirectly provide funds to borrowers. The term intermediary reflects the role of these institutions in
standing between savers and borrowers. Here we consider two of the most important financial
intermediaries: banks and mutual funds.
Banks pay depositors interest on their deposits and charge borrowers slightly higher interest on
their loans.
mutual fund an institution that sells shares to the public and uses the proceeds to buy a portfolio of
stocks and bonds
mutual fund = portfolio of stocks+bonds

 Saving and Investment in the National Income Accounts

Some Important Identities Recall that gross domestic product (GDP) is both total income in
an economy and the total expenditure on the economy’s output of goods and services. GDP
(denoted as Y) is divided into four components of expenditure: consumption (C), investment
(I), government purchases (G), and net exports (NX). We write
GDP(Y )=C + I +G+ NX
 This equation is an identity because every dollar of expenditure that shows up on the left
side also shows up in one of the four components on the right side. Because of the way each
of the variables is defined and measured, this equation must always hold. In this chapter, we
simplify our analysis by assuming that the economy we are examining is closed. A closed
economy is one that does not interact with other economies. In particular, a closed
economy does not engage in international trade in goods and services, nor does it engage in
international borrowing and lending. Actual economies are open economies—that is, they
interact with other economies around the world.
national saving (saving) the total income in the economy that remains after paying for
consumption and government purchases
private saving the income that households have left after paying for taxes and consumption
public saving the tax revenue that the government has left after paying for its spending
budget surplus an excess of tax revenue over government spending
budget deficit a shortfall of tax revenue from government spending
Savings = Private Savings - Public Savings
 The Market for Loanable Funds
market for loanable funds the market in which those who want to save supply funds and
those who want to borrow to invest demand funds
The economy’s market for loanable funds, like other markets in the economy, is governed
by supply and demand.
The supply of loanable funds comes from people who have some extra income they want to
save and lend out. This lending can occur directly, such as when a household buys a bond
from a firm, or it can occur indirectly, such as when a household makes a deposit in a bank,
which in turn uses the funds to make loans. In both cases, saving is the source of the supply
of loanable funds. The demand for loanable funds comes from households and firms who
wish to borrow to make investments. This demand includes families taking out mortgages to
buy new homes. It also includes firms borrowing to buy new equipment or build factories. In
both cases, investment is the source of the demand for loanable funds.
The nominal interest rate is the interest rate as usually reported—the monetary return to
saving and the monetary cost of borrowing. The real interest rate is the nominal interest
rate corrected for inflation; it equals the nominal interest rate minus the inflation rate.
 Policy Changes and Impact on the Loanable fund Market
Policy 1: Saving Incentives
Thus, if a reform of the tax laws encouraged greater saving, the result would be lower
interest rates and greater investment. This analysis of the effects of increased saving is
widely accepted among economists, but there is less consensus about what kinds of tax
changes should be enacted. Many economists endorse tax reform aimed at increasing
saving to stimulate investment and growth. Yet others are skeptical that these tax changes
would have much effect on national saving. These skeptics also doubt the equity of the
proposed reforms. They argue that, in many cases, the benefits of the tax changes would
accrue primarily to the wealthy, who are least in need of tax relief.
Policy 2: Investment Incentives
 Thus, if a reform of the tax laws encouraged greater investment, the result would be higher
interest rates and greater saving.
Policy 3: Government Budget Deficits and Surpluses
when the government borrows to finance its budget deficit, it reduces the supply of
loanable funds available to finance investment by households and firms. Thus, a budget
deficit shifts the supply curve for loanable funds to the left
When the government reduces national saving by running a budget deficit, the interest rate
rises, and investment falls. Because investment is important for long-run economic growth,
government budget deficits reduce the economy’s growth rate.
crowding out a decrease in investment that results from government borrowing

 Money-Meaning and Functions

money the set of assets in an economy that people regularly use to buy goods and services
from other people
medium of exchange an item that buyers give to sellers when they want to purchase goods
and services
Functions
unit of account the yardstick people use to post prices and record debts
store of value an item that people can use to transfer purchasing power from the present to
the future
liquidity the ease with which an asset can be converted into the economy’s medium of
exchange
Kinds
commodity money money that takes the form of a commodity with intrinsic value
fiat money money without intrinsic value that is used as money because of government
decree
 Money Supply
So far, we have introduced the concept of “money” and discussed how the Federal Reserve
controls the supply of money by buying and selling government bonds in open-market
operations. Although this explanation of the money supply is correct, it is not complete. In
particular, it omits the central role that banks play in the monetary system.
What determines the value of money? The answer to this question, like many in economics,
is supply and demand. Just as the supply and demand for bananas determines the price of
bananas, the supply and demand for money determines the value of money.
quantity theory of money a theory asserting that the quantity of money available
determines the price level and that the growth rate in the quantity of money available
determines the inflation rate
 Full Reserve Banking and Fractional Reserve Banking
 Central Bank Tools of Monetary Control
 Classical Theory of Inflation
of inflation by developing the quantity theory of money. This theory is often called
“classical” because it was developed by some of the earliest economic thinkers. Most
 economists today rely on this theory to explain the longrun determinants of the price level
and the inflation rate.
Inflation is an economy-wide phenomenon that concerns, first and foremost, the value of
the economy’s medium of exchange. The economy’s overall price level can be viewed in two
ways. So far, we have viewed the price level as the price of a basket of goods and services.
When the price level rises, people have to pay more for the goods and services they buy.
Alternatively, we can view the price level as a measure of the value of money. A rise in the
price level means a lower value of money because each dollar in your wallet now buys a
smaller quantity of goods and services.

 Classical Dichotomy and Monetary Neutrality

Hume and his contemporaries suggested that economic variables should be divided into two
groups. The first group consists of nominal variables—variables measured in monetary units.
The second group consists of real variables— variables measured in physical units. For
example, the income of corn farmers is a nominal variable because it is measured in dollars,
whereas the quantity of corn they produce is a real variable because it is measured in
bushels. Nominal GDP is a nominal variable because it measures the dollar value of the
economy’s output of goods and services; real GDP is a real variable because it measures the
total quantity of goods and services produced and is not influenced by the current prices of
those goods and services. The separation of real and nominal variables is now called the
classical dichotomy. (A dichotomy is a division into two groups, and classical refers to the
earlier economic thinkers.)
monetary neutrality the proposition that changes in the money supply do not affect real
variables
 Velocity and Quantity equation
velocity of money the rate at which money changes hands
V = (P × Y) / M
quantity equation the equation M × V = P × Y, which relates the quantity of money, the
velocity of money, and the dollar value of the economy’s output of goods and services
We now have all the elements necessary to explain the equilibrium price level and inflation
rate. Here they are: 1. The velocity of money is relatively stable over time. 2. Because
velocity is stable, when the central bank changes the quantity of money (M), it causes
proportionate changes in the nominal value of output (P × Y). 3. The economy’s output of
goods and services (Y) is primarily determined by factor supplies (labor, physical capital,
human capital, and natural resources) and the available production technology. In
particular, because money is neutral, money does not affect output. 4. With output (Y)
determined by factor supplies and technology, when the central bank alters the money
supply (M) and induces proportional changes in the nominal value of output (P × Y), these
changes are reflected in changes in the price level (P). 5. Therefore, when the central bank
increases the money supply rapidly, the result is a high rate of inflation. These five steps are
the essence of the quantity theory of money.
 Fisher Effect
 The Fisher Effect According to the principle of monetary neutrality, an increase in the rate of
money growth raises the rate of inflation but does not affect any real variable.
Real interest rate = Nominal interest rate Inflation rate.
Expected inflation moves with actual inflation in the long run, but that is not necessarily true
in the short run.
 Costs of Inflation
inflation tax the revenue the government raises by creating money
When prices rise, each dollar of income buys fewer goods and services. Thus, it might seem
that inflation directly lowers living standards.
shoe leather costs the resources wasted when inflation encourages people to reduce their
money holdings
menu costs the costs of changing prices